Accounting Theory PDF

TOPIC 2: FORMULATION AND VERIFICATION OF ACCOUNTING THEORY PART 1- SMA/UITM/PA  …………………recall: Theory formulation /construction A theory is defined as a set of interrelated...

TOPIC 2: FORMULATION AND VERIFICATION OF ACCOUNTING THEORY PART 1- SMA/UITM/PA  …………………recall: Theory formulation /construction A theory is defined as a set of interrelated constructs (concepts), definitions, and propositions that present a systematic view of phenomena by specifying relations among variables with the purposed of explaining and predicting the phenomena (Kerlinger, 1964). SMA/UITM/PA  should have descriptive approach in general and a normative (prescriptive) approach in particular. having the quality of authenticity and also authoritative. Must be wide acceptance. Characteristics The ability to evaluating and explaining the current events correctly. of ideal theory The ability analysing past events and forecast future events the potentiality of solving the problems created by the happening of an event. verifiable through testing of hypothesis. SMA/UITM/PA  How a particular accounting theory is useful? –The underlying assumptions  Classify the theories according to the (1)assumptions they rely on, how they are (2) formulated and their approaches to explaining and predicting actual events.   Pragmatic,  Normative,  Positive, and  Behavioural SMA/UITM/PA  Pragmatic theories Descriptive pragmatic approach Criticisms of descriptive pragmatic approach: based on observed behavior of does not consider the quality of an accountants accountant’s action theory developed from how does not provide for accounting practices to accountants act in certain situations be challenged tested by observing whether focuses on accountants’ behaviour not on accountants do act in the way the measuring the attributes of the firm theory suggests is an inductive approach SMA/UITM/PA  Pragmatic theories Psychological pragmatic approach: Criticisms of descriptive pragmatic approach: theory depends on observations of the reactions Criticisms of the psychological pragmatic approach: of users to the accountants’ outputs – some users may react in an illogical manner a reaction is taken as evidence that the outputs – some users might have a preconditioned response are useful and contain relevant information – some users may not react when they should Theories are therefore tested using large samples of people SMA/UITM/PA  This relation pertains to the effect of words or symbols on people Pragmatic How accounting concept and their real world corresponding events or object theories affect people’s behavior Example Release of accounting standard may Users of accounting report who base motivate some managers to support their action on the same information the standard or lobby to withdraw it SMA/UITM/PA  Normative theories  1950s and 1960s ‘golden age’  policy recommendations  what should be  concentrated on deriving:  true income (profit)  practices that enhance decision-usefulness  based on analytic and empirical propositions Financial statements should mean what they say SMA/UITM/PA  Features: Normative  Market-based theories which use methods other than historical cost method. Theories  Respective concepts of true income and financial position.  Assume profit maximisation is the primary goal of management.  Constructed on the basis of deductive reasoning.  Regard the provision of information for decision making as the main function of financial statements. SMA/UITM/PA  Normative Theories True income: Decision usefulness: a single measure for assets the basic objective of accounting is to a unique and correct profit figure aid the decision-making process of certain ‘users’ of accounting reports by providing useful accounting data SMA/UITM/PA  Normative theories  Normative approach is based on value judgments or personal opinion; and these value judgments cannot be verified or tested. SMA/UITM/PA  Positive theories Positivism or empiricism means testing or Expanded during the relating accounting Explain the reasons for 1970s hypothesis or based on current practice ‘experiences’ or ‘facts’ of the real world Test theories that Predicting the role of assume that People act in their own accounting information accounting information self interest in decision-making is an economic and political commodity SMA/UITM/PA  Positive theories Test theories that assume that accounting Why firms likely use SLM The theories of people act information is an rather than diminishing in their own self interest economic and political balance depreciation? commodity Look at costs and benefits of alternative accounting Managers incentives to methods and which choose accounting valuation models give the method best prediction of future returns, share prices, etc. SMA/UITM/PA  Main differences between normative and positive theories: Normative vs  Normative theories are prescriptive Positive ❖ Describe how accountant should behave to achieve an outcome that is judged to be right and good income  Positive theories are descriptive, explanatory or predictive ❖ Describe how people do behave regardless whether it is right, explain why people behave in certain manner or predict how people will react/ do? SMA/UITM/PA  BEHAVIOURAL THEORIES Derived from discipline such as psychology, sociology and organisational theories. Objectives is to discover why people behave as they do. According to Hofstedt and Kinard (1970), behavioural accounting research is defined as: “The study of the behaviour of accountants or the behaviour of non-accountants as they are influenced by accounting functions and reports” Encompasses: ▪ Judgement and decision making of accountants and auditors; and ▪ Influence of the output on users’ judgements and decisions making. SMA/UITM/PA  Behavioural Approach Important of Behavioural accounting research : ▪ Identifies how people use and process accounting information. Specifically, it examines the decision-making activities of the preparers, users and auditors of accounting information. ▪ Provides valuable insight into the ways of how different decisions are produced, processed and how people react to particular items of accounting information and communication methods. By improving the decision making process, users of financial information can avoid making bad decisions that lead to losses, and preparers and auditors of financial information can avoid being sued. SMA/UITM/PA  It can lead to training and increase in knowledge for accountants to improve their skills in information gathering, processing and communication. It can provide useful information to accounting regulators, particularly in the aspect of providing decision-useful information to the users of financial statements. Can directly study specific accounting options and then report to standard setters on which methods or disclosures improve users’ decision. It can lead to efficiencies in the work practices of accountants and other professionals. For example, a computerised expert system for decision making can be developed through the harnessing and recording of the expertise and skills of experienced accountants using the behavioural research methods. This system will then be used to train inexperienced practitioners. Some auditors have also used behavioural research methods to develop an expert system to conduct risk assessment of potential audit clients. SMA/UITM/PA  Formulation of Accounting Theory Deductive Inductive Ethical Approach Approach Approach Economic Sociological Approach Eclectic Approach Approach SMA/UITM/PA  Formulation of Accounting Theory under deductive and inductive Two approaches to theory formulation ❑ Deductive Approach The approach moves from the general (basic propositions or premise) to derive logical conclusion. Reasoning from general statements to specific statements Eg: All humans are opportunistic Managers are human Managers are opportunistic Based on normative theory SMA/UITM/PA  Formulation of Accounting Theory under deductive and inductive The construction of a Two approaches to theory begins with theory formulation observation and moves Inductive Approach toward generalized Eg: self interest -> wealth Based on positive theory conclusion. Reasoning maximization from particular statements to general statements PREDICTION: Manager A Manager A- bonus - Acc method A – Acc method B- decreases is more likely to opt for >reported profits: increases reported profit reported profit Acc method A SMA/UITM/PA  The deductive approach-what should be Steps used to derive the deductive approach Specifying the objectives Selecting the postulates of Deriving the principles of Developing the techniques of financial statements. accounting (assumption) accounting. of accounting. (Theories developed from general statement to specific statement/ to develop predictions, prescription or explanation on specific matters) SMA/UITM/PA  Premise 1: All asset accounts have debit balances. Premise 2: The land and building Example account is an asset account. Conclusion: The land and building account has a debit balance. SMA/UITM/PA The inductive approach Steps used to derive the inductive approach 1. Recording all observations observation (i.e. phenomena, event of things), 2. Analyzing and classifying and explain these observations to detect recurring relationships. 3. Inductive derivation of generalizations and principles of accounting from observations that depict recurring relationships (making conclusion). 4. Testing the generalizations. (Theories developed from specific statement/observation to develop general statement / implication of those observation ) SMA/UITM/PA  Premise 1: The Land and Buildings account is an asset account and has a debit balance. Premise 2: The motor vehicle account is an asset account and has a debit balance. Example Premise 3: The plant and machinery account is an asset account and has a debit balance. Conclusion: All assets accounts have debit balances. SMA/UITM/PA  In the deductive approach, the truth or falsity of the propositions does not depend on other propositions, but must be empirically verified. Comparing In the inductive approach, the truth of the deductive propositions depends on the observation of sufficient instances of recurring relationships. and inductive Accounting propositions that result from inductive inference imply special accounting techniques approach only with high probability. Accounting propositions that result from deductive inference lead, on the other hand, to specific accounting techniques with certainty. SMA/UITM/PA  The basis core consists of the concepts of fairness, justice, equity and truth The ethical In general, the concepts of fairness implies that accounting statements have approach not been subject to undue influence or bias. The committee on auditing procedures refers to fairness of presentation as conformity with GAAP, disclosure, consistency and comparability. SMA/UITM/PA  The sociological approach  Emphasizes the social effects of accounting techniques.  According to this approach, a given accounting principle or technique is evaluated for acceptance on the basis of its reporting effects on all groups in society.  Implies that accounting data will be useful in making social welfare judgments. SMA/UITM/PA  Emphasizes controlling the behavior of macroeconomic indicators that result from the adoption of various accounting techniques. The The choice of different accounting economic techniques depends on their impact on the national economic good. approach Accounting policies and techniques should reflect ‘economic reality’ and the choice of accounting techniques should depend on ‘economic consequences’. SMA/UITM/PA  SMA/UITM/PA  In general, the formulation of accounting theory and the development of accounting principles have followed an eclectic approach ( a combination of The eclectic approaches), rather than just one school of thought. approach  This approach is mainly the results of various attempt by professionals and government to participate in establishment of concepts and principles in accounting.  What is the purpose of accounting theory? How did accounting theory develop? REVISION What roles can theory play in relation to accounting? Give an example Using an accounting context, give an example of using induction to develop a theory. How can you evaluate the theory and its hypothesis? What is the scientific method? Describe two accounting issues that the scientific method can be used to resolve SMA/UITM/PA FORMULATION AND VERIFICATION OF ACCOUNTING THEORY PART 2: POSITIVE ACCOUNTING THEORY HOW IT DIFFERS WITH NORMATIVE THEORIST Learning objectives 7.1 Understand how a positive theory differs from a normative theory. 7.2 Be aware of the origins of Positive Accounting Theory (PAT). 7.3 Understand that PAT uses insights from agency theory and why agency theory is of relevance to financial accounting practices. 7.4 Be aware of the central assumptions of PAT. 7.5 Be aware of the meaning and nature of agency costs. 7.6 Understand why an organisation can usefully be referred to as a ‘nexus of contracts’. 7.7 Understand the perceived role of accounting in minimising the transaction costs of an organisation. continue d  Learning objectives (cont.) 7.8 Be aware that accounting policy choices made by management will be influenced by both efficiency considerations as well as opportunistic motivations. 7.9 Be able to identify the reasons for the existence of ‘creative accounting’. 7.10 Be able to explain the meaning of ‘political costs’ and how accounting can be used to reduce the costs associated with various political processes. 7.11 Understand the role of accounting-based management compensation schemes and debt covenants in reducing potential conflicts (agency costs) within an organisation. 7.12 Understand how particular accounting-based agreements with parties such as debtholders and managers can provide incentives for managers to manipulate accounting numbers. continue d Learning objectives (cont.) 7.13 Be aware of what constitutes ‘conservative’ accounting procedures and why conservative accounting procedures provide efficient mechanisms for minimising the contracting costs within an organisation. 7.14 Understand the relevance of PAT to current debates about how assets and liabilities should be measured. 7.15 Be able to identify some of the criticisms of PAT.  Positive theories compared to  normative theories A positive theory seeks to explain and predict particular phenomena  Positive Accounting Theory (PAT), which we explore in this lecture, is one example of a positive theory of accounting. Other examples are covered in the next lecture (when we consider theories such as Legitimacy Theory and institutional theories which are positive theories that can be applied to explain the practice of accounting)  By contrast, normative theories (which were considered in CF-TOPIC) prescribe how a particular practice should be undertaken  the prescription might depart from existing practice Positive Accounting Theory defined Again, positive theories do not prescribe what should occur – they focus on explaining or predicting what does occur continue d  PAT focuses on relationships between various individuals and explains how accounting is used to assist in the functioning of these relationships Positive Accounting Theory between owners and managers Examples of defined relationships between managers and the firm’s debt (cont.) providers Assumptions underlying PAT  All individuals’ action is driven by self-interest and individuals will act in an opportunistic manner to the extent that the actions will increase their wealth  does not incorporate notions of loyalty or morality  Started coming to prominence in mid paradigm shift from normative theories 1960s Origins of PAT 1970s and 1980s PAT became the dominant research paradigm in 1970s and 1980s shift resulted from US reports on business education, and improved computing facilities enabling large-scale statistical analysis – something common in positive research  Origins of PAT—capital markets research Development of Efficient Ball and Brown (1968) paper Markets Hypothesis (EMH) by was crucial to the acceptance Fama and others provided an of the positive research environment suitable for PAT paradigm research capital markets react in an investigated stock market efficient and unbiased manner reaction to accounting to publicly available earnings announcements information sought to explain market reactions continue d Origins of PAT—capital markets research (cont.)  Price of a security based on beliefs about present value of future cash flows  Ball and Brown found that earnings announcements impacted share prices  evidence that historical cost information is useful to the market  But the literature was unable to explain why particular accounting methods were selected – if the market was efficient as commonly assumed by researchers, and could understand how different accounting methods affect accounting numbers, then why does it matter what accounting method was selected? PAT addresses this issue  Firms can be characterised as a nexus of contracts between consumers of products and the suppliers of factors of production Firms exist because they reduce contracting costs, Firms and contracts firms provide an efficient means of organising economic activity [consider the alternative, an individual organising the production of a good: acquiring the raw materials organising various people to make the good] Contracts include all types of agreements between two or more parties (not necessarily written contracts)  Agency theory was crucial to the development of PAT Origins of Agency theory explained why the selection of particular PAT— accounting methods might matter agency Focused on the relationships between e.g. between shareholders (principals) and theory principals and agents managers (agents) Information transaction costs and asymmetries create information costs exist much uncertainty Agency relationship The ‘agency relationship’ is a central Defined by Jensen and Meckling Agency theory key assumptions from focus of agency theory (1976) the economics literature, such as: a contract under which one or more assumptions of self-interest and wealth (principals) engage another person (the agent) maximisation to perform some service on their behalf which involves delegating some decision-making authority to the agent Price protection In the absence of contractual Agents will therefore have mechanisms to restrict agents’ incentives to enter contracts potentially opportunistic which appear to limit actions behaviour, the principal will detrimental to agents pay the agent a lower salary compensates principals for adverse actions  At the core of the analysis is the ‘agency problem’ The agency problem relates to issues associated with motivating one party (the agent) to work in the best The agency interests of another party (the principal) problem Agency problems arise because of inefficiencies and information asymmetries The agency problem leads to ‘agency costs’  Monitoring costs costs of monitoring agents’ behaviour e.g. auditing financial statements Bonding costs Agency costs costs involved in agents bonding their behaviour to expectations of principals e.g. preparing financial statements Residual loss too costly to remove all opportunistic behaviour  Accounting information is used to address the agency problem and to reduce agency costs Role of accounting in contracts Accounting is used as a monitoring and bonding mechanism to control the efforts of self-interested agents (managers)  Three key hypotheses frequently used in PAT literature to explain, and predict support or opposition to, an accounting method Key bonus plan hypothesis debt hypothesis hypotheses political cost hypothesis Research assumes managers will act opportunistically when selecting methods Bonus plan hypothesis Managers of firms with bonus plans are more likely to use accounting methods that increase current period reported income  also called management compensation hypothesis  action increases the present value of bonuses paid to management  Debt hypothesis  The higher the firm’s debt/equity ratio, the more likely managers use accounting methods that increase income  also called debt/equity hypothesis  thehigher the debt/equity ratio, the closer the firm is to the constraints in debt covenants  covenant violation results in costs of technical default  Political cost hypothesis  Large firms rather than small firms are more likely to use accounting choices that reduce reported profits  size is a proxy variable for political attention  reduction of reported income is hypothesised to reduce the possibility that people will argue that the organisation is exploiting other parties Two Efficiency perspective perspectives adopted by PAT Opportunistic perspective research  Researchers explain how contracting mechanisms minimise agency costs of the firm Known as ex ante perspective Efficiency mechanisms put in place up front to minimise future agency and contracting costs perspective Managers select accounting methods which most efficiently reflect underlying firm performance PAT theorists argue that regulation forcing firms to use a particular accounting method imposes unwarranted costs and introduces inefficiencies  Seeks to explain managers’ actions once contracts are already in place That is, particular accounting methods might initially be selected for efficiency reasons, but once they have been negotiated/agreed, then managers will aim to utilise accounting choices in a way that best serves their own Opportunistic interest perspective Not possible to write complete contracts, so managers are assumed to opportunistically act to maximise own wealth Known as ex post perspective: considers opportunistic actions after the fact Owner/manager contracting  Assuming self-interest, owners expect managers (agent) to undertake activities not always in the interest of owners (principal)  Managers have access to information not always available to principals  information asymmetry  further increases managers’ ability to undertake activities beneficial to themselves  Costs of divergent behaviour are agency costs continue d Owner/manager contracting (cont.)  In the absence of controls to reduce opportunistic behaviour, agents (managers) expected to undertake activities disadvantageous to the value of the firm  Principals price this into the amounts they are prepared to pay the manager  Managers may contract themselves not to consume perks so will receive higher salary  known as bonding  Fixed basis— manager may not salary take great risks as independent of does not share in Methods of performance potential gains rewarding managers Salary plus remuneration known as bonus is, in part, tied to firm schemes performance  Remuneration can be tied to: profits of the firm sales of the firm Bonus return on assets schemes All based on output from the accounting system May also be rewarded in line with market price of the firm’s shares  Any changes in accounting methods will affect the bonuses paid Accounting- may occur as a result of a new accounting standard in place based Contracts in some circumstances may be based on the old method in place bonus plans so changes will not affect bonuses Contracts relying on accounting numbers may rely on ‘floating’ GAAP Incentives to manipulate accounting numbers The decision to reward managers on the basis of accounting profits might initially be introduced for efficiency reasons (it motivates Bonuses based on profits cause short-term them to work in a way that also benefits the rather than long-term focus principals), but it may subsequently induce them to manipulate accounting numbers (the opportunistic perspective) a change in accounting numbers will affect may affect investment in positive NPV their rewards projects if returns not expected to be consistent TO BE DISCUSSED FURTHER IN CREATIVE ACCOUNTING’S TOPIC.  PAT is not value-free as Does not provide it asserts assumption prescription that all action is driven by self-interest Criticisms of Argued to be too negative and simplistic a perspective of Issues have not shown great development PAT humankind In undertaking large- scale empirical research, researchers ignore organisational- specific relationships Diagrammatic summary of PAT